Common Mistakes in Annual Financial Statements of Urban Local Bodies
Time for auditor of urban local bodies to rethink their methodology
CA. Pankaj Goel
Member of the Institute | Contact: eboard@icai.in
“Personnel preparing the accounts and eventually Annual Financial Statements (AFS) from accounts under any accounting package shall ensure that financial statements shall not mislead users of AFS. This can be done by satisfying that accounts have been drawn up with reference to entries in the books of account and information conveyed by statements is clear and unambiguous. Audited Financial Statements of any Urban Local Body (ULB) can be found on the Urban Department portal of any State as publishing of audited financial statements has become a mandatory condition for claiming grants under 15th finance commission as ‘Audited accounts to be published for all ULBs on State/ULB website for the year before the preceding year w.r.t the award year’.”
After examining the AFS of many cities including Smart cities, it has been observed that there are many mistakes in Annual Financial Statements of Urban Local bodies which surprisingly most city accountants, and third parties preparing or auditing these Annual Financial Statements generally can not determine. The prime reason could be a lack of understanding about guidelines applicable to Urban Local Bodies or due to limited time or value of the project under which these AFS have been prepared or audited.
This article has been written to highlight these mistakes without mentioning any ULB so that policy makers may decide to revamp the guidelines if required and conduct training sessions for both ULB accountants and third parties preparing and auditing these AFS. Article addresses the rationale for a transition from old archaic way of preparation and presentation that is in the interest of all stakeholders.
Introduction: Auditing Logic & Constitutional Governance
Accounting and Auditing are closely related to each other as auditing reviews financial statements which are nothing but a result of the overall accounting process. Thus, it is expected that the auditor is aware of not only generally accepted accounting principles but also of the actual working of the organization with applicable guidelines and statutes. Auditing itself is based on the concept of logic and everything done in auditing must be bound by the rule of logic. Auditing has close relation with the law and thus it is expected that the auditor carrying out the audit must have sound knowledge of governance applicable to an entity for urban local bodies Municipal Acts, National Municipal Accounting Manual (NMAM) / State Municipal Accounting Manual (SMAM) Guidelines, Rules/Byelaws and it must be adhered.
The 74th Constitutional Amendment Act had entrusted additional powers and responsibilities to Local Self Governments in India through 18 functions to be discharged by ULBs. In this changed scenario, the financial reporting quality of local bodies assumes great importance as it is a means towards ensuring achieving two most significant objectives i.e., transparency and accountability. AFS shall help the user to assess liquidity, the solvency of the entity and its requirement for additional financing and paves the way to access market financing (such as Municipal Bonds). However, the financial information provided by the financial statements of ULBs at present loses its value if it is not as per applicable guidelines or lacks relevant annexures or has fundamental mistakes.
These AFS are the basis for making financial projections for resource generation by cities to fund infrastructure which is part of the City Development Plan (CDP) of the city or revenue improvement plans prepared using information about receipts and payments in AFS. AFS having mistakes will lead to a fundamental misinterpretation of facts and false projections.
Financial Reporting: Governance Disparity & Historical Initiatives
When we can have rigorous guidelines for the corporate sector like Accounting Standards, Auditing Standards, The Companies Act 2013, and other related provisions updated periodically, why can we not have similar binding frameworks for Urban Local Bodies—the primary delivery arms of Government citizen services? Except NMAM and SMAM, no comprehensive statutory manuals exist.
Table 1: Key Regulatory Initiatives Taken to Improve Municipal Financial Reporting
| # | Stakeholder | Initiative Details |
|---|---|---|
| 1 | Ministry of Urban Development | Issued the National Municipal Accounts Manual (NMAM) in November 2004. |
| 2 | National Institute of Urban Affairs (NIUA) & MoUD | Formulated the Model National Municipal Asset Valuation Methodology Manual (MNMAVMM) in 2009. |
| 3 | Institute of Chartered Accountants of India (ICAI) |
• Pronouncement on “Framework for the Preparation of Financial Statements under Indian Accounting Standards” (2020). • In 2015, issued Compendium of Accounting Standards for Local Bodies (ASLBs) (e.g., ASLB 1, 5, 9, 11, 12, 14, 17). Total 31 ASLBs issued including one cash-based standard. • Mandate: 2 ASLBs (ASLB 2 & ASLB 5) have been made mandatory by ICAI for members auditing Local Bodies w.e.f. April 1, 2022. |
| 4 | 15th Finance Commission | Audited accounts to be mandatorily published on State/ULB website for the year before preceding year w.r.t. award year (e.g., FY 2019-20 accounts published to qualify for 2021-22 grants). |
| 5 | AMRUT Mission | Complete migration to double-entry accrual accounting system with publication of AFS on website and audit certification from FY 2012-13 onwards. |
Critical Observation: The NMAM was drafted over 18 years ago and has never been systematically reviewed against ground-level AFS. Currently, ULBs treat AFS as a mere box-ticking exercise to claim grants without independent validation of the accounts.
Common Mistakes in Municipal Financial Statements
An accounting mistake in a municipal entry or grouping arises from a lack of accounting knowledge, misinterpretation of guidelines, or silence in the NMAM/SMAM manuals.
A. Omission in Mandatory Reporting Components
Chapter 31 of NMAM (“Financial Statements”, Para 31.4) mandates that the Annual Report shall comprise:
- Balance Sheet
- Income and Expenditure Statement
- Statement of Cash Flows
- Receipts and Payments Account (detailed by account heads)
- Notes to Accounts
- Financial Performance Indicators
Defect: In practice, almost no ULB or State prepares or audits Financial Performance Indicators.
B. Improper Valuation of Fixed Assets (The Re. 1 Token Trap)
While cities are accessing debt markets through Municipal Bonds where rating agencies demand realistic asset backing, prime municipal lands and infrastructure with immense value continue to be recorded at token values of Re. 1 under legacy MNMAVMM provisions, ignoring the revaluation model. This severely depresses municipal balance sheets and artificially constrains borrowing borrowing power.
C. Fundamental Accounting Entries Violations
Example 1: Booking Property Tax Receipts Directly Without Raising DEMAND
Under Para 3.6(a) of NMAM, revenue from Property and Other Taxes must be recognized on an accrual basis in the period when they become due and demands are ascertainable. In practice, software packages directly credit tax revenue upon cash receipt without establishing demand.
| Current Defective Process | NMAM Statutory Provision (Chapter 6) |
|---|---|
|
Receipts are directly booked under: Code 11001-01 (Tax Revenue) |
1. First, raise Demand under Code 431 (Property Tax Receivable):Dr. 431 - Property Tax Receivable To 110 - Tax Revenue2. Upon collection, route through Code 431: Dr. 450 - Bank A/cDr. 240 - Rebate on Property Tax To 431 - Property Tax Receivable To 180 - Other Income: Fines To 350 - Income in Advance
|
Example 2: Misclassifying Advertisement Fee (14040-01) as Advertisement Tax (11011-01)
Post-GST implementation in July 2017, Entry 55 of the State List (Advertisement Tax) was subsumed under GST. State Municipal Acts should have been amended to reclassify hoarding charges as non-tax regulatory fees (Code 14040-01). Because many States failed to amend rules, ULBs misclassify hoarding fees under Advertisement Tax (11011-01), artificially underassessing non-tax revenues.
Example 3: Wrongly Booking Grant Bank Interest as ULB Own Source Income
Interest earned on unspent balances of tied Central/State grants (PMAY, SBM, AMRUT, 15th FC) is erroneously booked under Code 17110-01 (Interest from Bank Accounts), artificially inflating the ULB’s self-generated Own Source Revenue. Under Fund-Based Accounting principles (AS 12 & NMAM Chapter 17), interest earned on grants belongs to the grantor and must be credited directly to the grant corpus.
| Current Defective Booking | NMAM Chapter 17 Mandate (Fund Accounting) |
|---|---|
Dr. Bank A/c To 17110-01 Interest from Bank AccountDistorts Own Source Revenue |
Dr. Bank A/c To 32010-01 Grants/Contribution for Specific PurposesCredited directly to Grant Liability |
Example 4: Booking Expenditures Under Erroneous Accounting Heads (Table 4)
| Current Error | NMAM Chapter 14–16 Correct Code |
|---|---|
| Independence Day / Republic Day celebration expenses booked under Code 22011 (Office Expenses) | Must be booked under Code 25020 (Own Programmes) |
| Daily sanitation wages (Saf Safai) lumped together with Contractual staff salary under Code 21010 (Salary & Wages) | Separate distinct ledgers required for Wages versus Salary to Contractual Staff under Code 21010 |
Example 5: Non-Recording of Opening Arrears of Property Tax Receivables
Uncollected property tax from prior years is not brought forward as Opening Receivables. Consequently, when arrears are collected, they are recorded as current revenue without adjusting receivables, producing pervasive distortion in municipal liquidity and recovery ratios.
Way Forward: 8 Fundamental Questions for Policy Makers
When listed companies face stringent disclosures because they utilize public equity, why should Urban Local Bodies—which deploy immense public tax funds for civic service delivery—remain exempt from rigorous compliance? The path to reform requires confronting eight critical governance questions:
Recommendations for ICAI & Decision Makers
- Develop a standardized digital portal and financial dashboard for all ULBs integrated with an automated audit verification checklist.
- Constitute an expert ICAI review group to scrutinize sample city accounts, identify recurring accounting errors, and publish comprehensive Guidance FAQs.
- Mandate transparent public disclosure of Significant Accounting Policies (SAP) and municipal asset registers.
References
- Government of India, Ministry of Urban Development (2005). Jawaharlal Nehru National Urban Renewal Mission (JnNURM). December.
- YASHADA (2009). Report on Best Practices in the Financial Management of Urban Local Bodies in India. Submitted to Ministry of Housing and Urban Poverty Alleviation, Government of India. June. Pune: Yashwantrao Chavan Academy of Development Administration.
- Government of India, Ministry of Urban Development (2015). Smart City Guidelines, June 2015.
- Government of India, Ministry of Urban Development (2015). Atal Mission for Rejuvenation and Urban Transformation (AMRUT). June 2015.
- Government of India (2021). The Report of the Fifteenth Finance Commission (2022–2026).
- Government of India, Ministry of Housing & Urban Affairs (2022). Reform Toolkit for AMRUT 2.0; 2022.
- Annual Financial Statements of Selected Municipalities.